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Libor's Ascent Is New Culprit for Hedged Treasury Yields Near 0%

(Bloomberg) -- A phenomenon rippling through global funding markets is poised to keep overseas investors wary of Treasuries just as the U.S. needs them most.

It starts with the London interbank offered rate, among the most-watched benchmarks in finance lately. The rate on the three-month maturity has climbed for 36 straight sessions, raising the baseline for many bonds, loans and mortgages. The surge has also made it much more expensive for European and Japanese investors to buy Treasuries and hedge out currency risk. The main reason: Paying U.S. Libor is part of such transactions.

It’s hardly the first time that shifting global markets inflated the cost of this trade. But what’s unusual in this episode is that Libor is the culprit, as opposed to another leg of the exchange, the cross-currency basis. Either way, it comes at an inconvenient time for the U.S. Treasury, which is boosting auction sizes to plug mounting deficits.

“While the cross-currency basis has been much better behaved, it’s Libor that’s raising the hedging cost for the overseas investor to buy Treasuries,” said Timothy High, U.S. strategist at BNP Paribas SA.

In the past two years, it’s been fluctuations in the basis that have largely been responsible for periods when the yield pickup on Treasuries over other sovereign debt was basically wiped out for investors who hedge.

Libor’s Turn

This time could hardly be more different: It costs just six basis points to convert euros into dollars, around the least since 2014 and down from about 105 basis points in December. For yen-based investors, the basis turned briefly positive this week for the first time since 2012.

What it all boils down to is that 10-year Treasuries yield just 0.42 percent in Japan and 0.06 percent for euro holders after hedging, compared with about 2.76 percent unhedged.

To grasp the math, here’s a recap of how euro-based investors acquire dollars to purchase U.S. debt and hedge the FX risk: They pay dollar Libor (2.31 percent) and the basis (0.06 percent), while also effectively paying their local Libor because it’s negative (minus 0.37 percent). Added together, the expense almost offsets the 10-year Treasury yield.

The surprise, though, is that Libor, which regulators have been trying to phase out, is the driver.

U.S. three-month Libor has jumped about 60 basis points in 2018 amid Federal Reserve rate hikes and a flood of Treasury bills. That deluge is pushing up rates on commercial paper, feeding back into higher Libor.

As for the cheapening cross-currency basis, it starts with the U.S. tax overhaul, according to Credit Suisse Group AG analyst Zoltan Pozsar. In addition to enticing American companies to repatriate money, there’s a provision that’s changing how foreign companies finance U.S. affiliates.

Funding Glut

Essentially, they’re not sending money to America anymore. That’s making excess cash available for foreign-exchange swaps, creating a glut of dollars in the system instead of the shortage that plagued funding markets in recent years.

“Usually basis swaps are the culprit” for elevated hedging costs, said Tetsuo Ishihara, U.S. macro strategist in the fixed-income division of Mizuho Securities USA in New York.

“But Libor is different this year,” he said. “When Japanese investors decide, it’s about the outlook for them. If they think Libor is going to keep rising and their hedging cost is going to keep getting worse, then they won’t step in.”

The outlook may be getting less gloomy. The pace of Libor’s increase has slowed, and it may come to a halt as T-bill issuance eases. JPMorgan Chase & Co. strategists say the spread between Libor and the overnight index swap rate may even tighten as the Treasury receives tax payments in April.

For now, though, Japanese holdings of Treasuries are near the lowest in six years. The country’s fiscal year starts April 1, and the first few weeks aren’t seasonally strong periods of foreign bond purchases.

Investors could, of course, buy without protecting against currency risk, but they may be reluctant to do so given the pessimism surrounding the dollar. Speculators are about as bearish on the greenback as at any time since 2013.

Any pullback from overseas raises the specter of higher borrowing costs for the Treasury. After this week, the next big test of demand comes in April, when the U.S. offers three- and 10-year notes, plus 30-year bonds.

So in addition to domestic corporate bonds, Australia’s financing markets and Saudi Arabia’s efforts to stem capital flight, add U.S. taxpayers to the list of those feeling the pinch of Libor’s surge.